Technical analysis is one of the two main areas of study (along with fundamental analysis) in forex. An analyst looking at a chart always tries to internalize certain aspects of the price movements they see.
Is the trend changing or continuing? What is the magnitude of the momentum, weak or strong? Is price approaching key support and resistance? Although it’s a contentious issue whether these elements are the primary underlying drivers of price, we still need to use this technical analysis in our decision-making.
As one can expect, you can study so many things about price. However, this article will explore the three critical technical analysis concepts which are very much applicable and observable for any forex trader.
It’s often said the trend is your friend. Ultimately, trading forex is about identifying trends, and equally important is also about seeing them early before new ones form. We specify a trend as the tendency for price to move in an overall direction for a defined period.
More specifically, we characterize a trend by a series of lower lows and lower highs (for a downtrend) and higher highs and higher lows (for an uptrend). Trend analysis is easily the most subjective notion to deal with in currencies consistently for several reasons.
The sheer number of time frames at our disposal makes it challenging to determine one definitive trend. Markets are technically moving in several trends simultaneously (short-term, medium-term, and long-term) depending on the charts you’re observing, your trading style, and what you inherently believe about what causes them, bringing us to the next point.
So, what actually drives a trend in the first place? Like most things in forex, there is no universally accepted answer, and this topic continues to be contentious. Most literature can agree it boils down to two things, market psychology and fundamentals.
The former is the premise of herd mentality, the natural tendency for humans to follow the crowd. If the price keeps rising, there’s a higher chance it will keep going up (and vice versa). We also cannot ignore a few critical fundamental data, especially interest rates that affect long-term movements.
Regardless of the true winner between the two, traders use a combination of technical and fundamental indicators to work out the trend as it’s one of the critical decision factors for someone to place a buy or sell order.
If you’re thinking of the physics definition for momentum and relating it to currencies, you wouldn’t be far off. Physicists define momentum as the ‘quantity of motion,’ a concept which very much applies to trading. Essentially, the quantity is how forcefully the price is ‘in motion.’
While trends offer a directional bias, momentum tells us the strength and weaknesses of those movements. It provides traders information about the buying and selling pressure and how likely it is to shift from one side to the other. Let’s consider the importance of why momentum is so crucial to understanding.
We all know prices move in ‘waves’ known as retracements. Let’s assume price was in an overall strong uptrend for several weeks and began correcting itself with deep pullbacks for a while.
It’s quite common for most people to begin assuming the trend is reversing based on something like a trend line break, the simple idea of highs and lows, etc. Yet, the market is likely to eventually make a new high not only because of crowd psychology but also because of bullish momentum.
Momentum gives us the rate of acceleration and deceleration. If there is still ‘force to the upside,’ pullbacks against the prevailing trend don’t necessarily mean the market will begin a new substantial trend.
Momentum is technically less subjective and easier to quantify than the trend since several indicators like the Relative Strength Index provide the best possible readings. Once you can confirm the momentum across multiple time-frames, you can better understand where price may begin to move forcefully in one direction or another.
3: Support and resistance
If you look at any chart on any time frame, it’s easy to tell price seems to constantly keep bouncing up and down around similar areas over time. In a nutshell, this phenomenon is support and resistance.
It’s the one concept allowing traders to buy as low as possible in an up-trending market or sell as high as possible in a down-trending market. Support refers to when price stalls at a certain area and starts moving up, while resistance refers to price stalling at a particular area before moving down.
It’s hard to argue about the evidence that prices are constantly moving through zones of ‘floors’ (support) and ‘ceilings’ (resistance). Moreover, such areas keep getting broken, where support turns to resistance or resistance to support, a momentous event occurring frequently.
But why is this notion so important in forex? Is it all a random coincidence? Similar to the trend, support and resistance boil down to market psychology, plus a bit of supply and demand).
Markets tend not to forget about such areas which have produced moves of some magnitude in the past. When price does approach so-called strong support or resistance level, everyone can see it.
For support, the bulls (buyers) remember the power they had before at a certain area and may begin convincing others to change their bias for whatever reason (and vice versa for resistance).
We should also consider the interest of buyers and sellers through the supply (support) and demand (resistance). If supply outweighs demand or vice versa, then the price will undoubtedly change direction to a small or large extent.
These are some of the dynamics surrounding support and resistance, reinforcing why this idea is at the core of any skilled technical analyst.
As a technical trader, you have several options for internalizing these concepts. It’s usually better to use them in combination instead of only relying on one thing.
Regardless of the elements you choose to incorporate in your decision-making, it’s important to understand exactly how each works and how they might influence price movements. Markets are naturally chaotic, reinforcing the high level of uncertainty in the markets.
Yet, price action is not always completely random, and amid all the chaos, we can take advantage of identifiable and repeating patterns over time through technical analysis.